There are nearly endless opportunities available for those who have ideas for building successful businesses. However, starting a business involves more than a great idea and a solid business plan. An entrepreneur will have numerous options when determining the appropriate legal structure for their business. The type of business entity can significantly impact the ownership and management of the business, as well as the liability of the owner and partners or investors, the taxes that must be paid, and the day-to-day operations.
Understanding the available options may help new business owners make informed decisions about how to organize and protect their ventures. Current business owners may also benefit from understanding how a business may be restructured in order to raise funding, protect against liability, and allow for more flexible management.
The Simplicity and Risks of Sole Proprietorships
A sole proprietorship is the simplest form of business ownership. It exists when one person owns and runs a business without forming a separate legal entity. There are a few formal requirements to begin operating a sole proprietorship, and a person will likely need to obtain a local business license or register the name of their business.
This simplicity, however, comes with significant risk. In a sole proprietorship, there is no legal distinction between the owner and the business. The owner is personally responsible for all business debts and obligations. This means that their personal assets, such as bank accounts, vehicles, or even their home, could be at risk if the business faces financial difficulties or lawsuits. While a sole proprietorship offers complete control and minimal paperwork, it provides no liability protection.
Forming a Partnership with Multiple Owners
When two or more people decide to operate a business together, they may choose to form a partnership. Partnerships can be established through an oral or written agreement, but a written contract is strongly recommended to clarify the rights, responsibilities, and profit-sharing arrangements between partners.
There are several types of partnerships, each with different levels of liability and involvement:
General Partnerships
A general partnership is a basic type of business partnership. All partners will share equally in management and profits, but they will also be personally liable for the business’s debts and obligations. Each partner can enter into contracts or transactions, which means trust and communication are essential.
While general partnerships are easy to form, the shared liability can be a significant risk. If one partner incurs a debt or is involved in a lawsuit, all partners may be personally responsible.
Limited Partnerships
A limited partnership includes at least one general partner and one or more limited partners. General partners will be responsible for managing the business and assume full personal liability, while limited partners may contribute capital and share in profits, but they will have limited personal liability. Limited partners are generally not involved in daily management.
This structure may help investors to contribute financially to a business while limiting their risks to the amount of their initial investment. It may be a good way for general partners to maintain control of a company while raising capital, but it exposes general partners to liability risk.
Limited Liability Partnerships (LLPs)
A limited liability partnership provides more protection for its partners. In an LLP, each partner is considered a limited partner and typically cannot be held liable for the actions or debts of the other partners. LLPs combine the shared management flexibility of a partnership with added liability protection. They are often used by professional groups such as law firms, accounting firms, or medical practices.
The Advantages of Limited Liability Companies
A limited liability company (LLC) has become one of the popular choices for many small and medium-sized businesses. It combines the operational flexibility of a partnership with liability protection.
Owners of an LLC, referred to as members, are generally not personally liable for the business’s debts or legal claims. The LLC itself is treated as a separate legal entity. Additionally, there are several options for taxation, allowing members to determine whether it may be beneficial to have an LLC taxed in a manner similar to that of a sole proprietorship, partnership, or corporation. These decisions may be based on factors such as the number of members and the method of distributing profits.
The structure also allows for flexible management arrangements. Members may be directly involved in business management or appoint managers to handle operations. This balance of simplicity, flexibility, and protection makes LLCs an appealing option for many entrepreneurs.
Structuring a Business as a Corporation
Corporations are more formal business entities that exist as separate legal persons under the law. They provide strong liability protection to their owners, who are known as shareholders. A corporation can enter into contracts, own property, and be sued independently of its shareholders.
There are two main types of corporations:
C-Corporations
A C-corporation is the traditional corporate structure. It offers the strongest liability protection and the ability to raise capital through the sale of stock. However, C-corporations are subject to “double taxation” in which profits are taxed at the corporate level, and dividends distributed to shareholders are taxed again as personal income.
C-corporations are often used by larger businesses or those that are seeking to attract investors. They allow for multiple classes of stock, and there are typically no limits on the number of shareholders.
S-Corporations
An S-corporation provides similar liability protection as a C-corporation but is taxed differently. Profits and losses are passed through directly to shareholders. These amounts are reported on the shareholders’ individual tax returns, avoiding corporate-level taxation and allowing for deductions that may be available.
To qualify as an S-corporation, a business must meet specific requirements, including having a limited number of shareholders and issuing only one class of stock. S-corporations are often chosen by small to medium-sized businesses that want corporate protection with simplified taxation.
The Role of Legal Agreements in Business Formation
Regardless of the chosen structure, clear and comprehensive legal agreements are essential. These documents will define how the business will operate, how decisions will be made, and how disputes will be resolved. They also help prevent misunderstandings while protecting the interests of everyone involved.
When forming a partnership, the partners can enter into a partnership agreement. This contract will outline each partner’s responsibilities, detail how profits will be distributed, and provide procedures for adding or removing partners. In an LLC, an operating agreement will specify how the business will be managed, how profits will be shared, and the steps that will be followed when a member leaves or the business dissolves. A shareholder agreement will outline the rights and obligations of corporate shareholders, including voting rights, procedures for transferring shares, and guidelines for resolving conflicts. These agreements serve as the foundation for smooth governance of a business, and they can help ensure that owners, partners, or members will be able to address issues that may arise during the life of the business.
Understanding the Options for Structuring a Business
Choosing the right business entity is one of the most important decisions made by an entrepreneur as they establish a new business or make sure an existing business can operate successfully. Sole proprietorships, partnerships, LLCs, and corporations each offer distinct advantages and potential drawbacks. Factors such as liability, taxes, ownership structure, and administrative concerns may need to be considered. A business law attorney can provide guidance on the available options and help ensure that the appropriate steps are taken when establishing a business entity and implementing the necessary legal agreements.
Disclaimer: The information provided in this article is for general informational purposes only and is not intended as legal, financial, or professional advice. While we strive for accuracy, we make no representations or warranties, express or implied, about the completeness, accuracy, reliability, suitability, or availability of this information. Use of this information is at your own risk.
